Can We Think Mid-Caps Again?

Ali On Content / 17 Jan 2011

With returns of over 30 per cent, the CNX mid-cap index did a pretty good job in the first ten months of 2010, much higher than the 21 per cent returns Special Report given by the broader market – the Nifty. And with no immediate negative triggers then, it seemed nothing could have jinxed the progress of mid-caps. While this was more or less the market consensus then, no one seemed to be prepared for what followed. A string of bad news over the next one month wiped out most of the gains of the preceding ten months. The 2G scam rattled the broader markets, but what really dented investor confidence was negative news that gripped the mid-cap space after the unearthing of the LIC Housing scam. Allegations of price rigging of mid-cap stocks with the involvement of some of the management executives raised questions yet again on the corporate governance front. In fact, since its Diwali peak the market hasn’t been able to sustain its levels. While the Nifty slipped by more than 8 per cent, the CNX Mid-Cap Index has performed the worst, declining by almost 15 per cent. Thus, with most of the gains wiped out, the one-year returns of mid-caps stand stunted at mere 11 per cent, similar to the performance of the Nifty. The unearthing of such scams is the last thing that the markets wanted and have indeed had a very negative impact on the rally. No wonder investors reacted so sharply and dumped mid-cap stocks across the board in a reaction which was obvious and intended to safeguard their gains.


The Worst Affected
Just to get a view of how worse this fall has been, since November 1, 2010 till date, of the total 100 CNX mid-cap stocks, 88 per cent or 88 scrips have given negative returns. The balance managed to stay in the black with the maximum return being a mere 8 per cent. Of these 88 scrips, 44 per cent or 39 scrips have fallen by more than 15 per cent. The top five worst hit amongst these were Ackruti City, which is down by 51.42 per cent, IndiaBulls Real Estate (39.51 per cent), LIC Housing (36.68 per cent), Welspun Corp (36.27 per cent), and Housing Development and Infrastructure


Besides, the other interesting fact worth mentioning here is that most of these scrips which have declined belong to the financial services sector. Twelve of these are public sector banks and stocks from the construction and real estate space. The others in the list include sectors such as auto ancillary, chemicals, media, power, refineries, shipping, steel and telecommunications.


Future Possibilities
One school of thought remains pessimistic about the outlook for the mid-caps. This is particularly because of the ongoing SEBI investigation and news that SEBI is expected to come out with names of more companies whose prices may have been rigged. The second school of thought feels that as far as the mid-caps are concerned, the worst is already priced in. We are more confident of the second scenario. This is because the recent events have had a two-fold impact. One is that the valuation froth that was built during the pre-Diwali rally has come off. This has happened across the board and hence there would be better bargains available in the market. Secondly, with the SEBI stepping up its vigilance further, it would only help cleanse the market, thereby restoring investor faith in the system.


Besides this, the market tends to have a short-term memory and it is only about time that it will take a new course. In fact there are two major triggers that we see for the market going ahead. First, the December quarter results would now start to pick up pace and considering that the numbers are better on account of festivities, the markets would closely follow these numbers to take a cue forward. The second trigger would be the budget, which would attract more eyeballs as investors would be interested to know of the government’s plans for the coming fiscal and the steps it is likely to take to keep the deficit in check, whilst maintaining the growth momentum. Thus, the worst is already priced in and the downside looks limited from here on.[PAGE BREAK]


Other Concerns
However, the only two factors that could be of concern right now are inflation and interest rates. Food inflation continues to be rampant and is seen touching new highs, while commodities, including crude, on the other hand continue to march ahead as well. All this would push the overall inflation numbers on a higher side despite the government’s assurances of controlling it within permissible limits. This may put the RBI in a fix, which may then tighten the interest rates further. These factors aren’t just specific to India, but also other Asian economies such as China and Indonesia, where the stock market is reacting quite sharply to speculation about the central banks raising rates to curb inflation. Thus any news related to inflation and interest rates would be closely followed by the investor fraternity, thereby keeping the market under pressure.



Do Mid-Caps Make Sense Then?
Our answer to this question is an astounding yes. As surprised as you may seem, but this is how we feel. The mood in the market is obviously sombre with a possibility of investors expecting even worse in the coming days. But this is the time to think different from the herd and take a contrarian view on the mid-cap space. In short, buy when everybody is selling. Thus while investors are focusing on dumping high beta stocks such as mid-caps, our focus is on the valuations froth that has come off big time. Since its Diwali peak, the Nifty has come off by 8 per cent, while the CNX Mid-Cap Index has seen a very sharp dip of almost 15 per cent.


At this peak level, while the Nifty was available at trailing PE of 25.59x, the CNX Mid-Cap was trading at 23.13x. However, if we look at the valuations currently, then the Nifty is available at 23x, while CNX Mid-Cap is trading at 18.77x. Thus a sharp correction in the valuations of the mid-caps has happened compared to the frontline stocks, making this space more attractive. With the value that has emerged after such a deep correc-tion, investors certainly have an oppor-tunity for bargain hunting. Further, though investors are concerned about the recent allegations of price rig-ging in the mid-cap space, what one tends to forget is that those stocks which are a part of the CNX Mid-Cap Index are fundamentally strong com-panies and are well-tracked by the investing fraternity.

And while there are questions being raised on the corporate governance issues in this space, we believe these would continue to remain. However, with the SEBI getting into the act there would definitely be a progres-sive move in the future towards better transparency and a cleaner market. The reason why mid-caps become an attractive proposition is because of their high growth rate and in turn their ability to create that better alpha for your portfolio.

One therefore cannot ignore this space. But this doesn’t mean a random picking of stocks. In this volatile mar-ket, the prudent strategy for investors would be to take a stock-specific call. Only after one is satisfied with his or her due diligence and does find value in the same, can one surely take a call from a long-term perspective.

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